Mutual Funds, Simplified
Most people have heard of mutual funds, but many don’t know what they are. In this article, I’m going to break down mutual funds into their basic building blocks so you can understand what they are and begin to determine whether you should invest in one.
Mutual funds, defined
Mutual funds are an investment vehicle that holds other investments, otherwise known as “holdings.” These holding are stocks, bonds, cash, or other assets.
One way to think about a mutual fund is to imagine it as a dish full of marbles, where each marble represents a holding. One marble may represent a stock investment in the automobile industry; another marble could represent an investment in a government bond; another marble could represent a stock investment in Nike. There are many marbles, so the list could go on and on.
A mutual fund is also a security—a financial asset that can be traded on the stock market.
As a shareholder in a mutual fund, you do not own a share of the individual holdings (the marbles). You own a share of the mutual fund (the dish). And you are one of many other investors who own a share of the fund, which is managed by an individual professional or a team of investment managers.
You can also refer to a mutual fund as a portfolio. Like all portfolios, the holdings of a mutual fund are diversified, which means that they include a variety of holdings/investment types that each have their own level of risk.
By spreading your investment across a variety of holdings, you reduce your risk of losing money. In other words, though one of the holdings may perform poorly (causing you to lose money), other holdings may perform well (causing you to gain money). In this way, the high-performing holdings will cover or lessen the loss caused by the poorly-performing holdings.
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Benefits and drawbacks, revealed
Mutual funds have a lot of benefits. For example, they’re
- easy to understand;
- simple to use;
- available at a minimal investment;
- and versatile, as you’ll learn if you keep reading.
One drawback of mutual funds that they are constructed and managed by someone else. In other words, you don’t get to choose what goes into it, and its performance is only as good as the person or team that is managing it. Mutual funds are more liquid (easy to exchange for money) than stocks and bonds, and in most cases you will pay ongoing management fees. Fees vary widely, so make sure to ask your financial advisor how they fee before you agree to purchase a mutual fund.
Risk tolerance, considered
When you speak to a financial advisor about investing in a mutual fund, they will start by assessing your risk tolerance by asking a few questions. These questions help them determine how sensitive you are to losing money in the short term even if you could potentially gain money in the long term.
The stock market can be volatile and your financial advisor can help you find a mutual fund that takes into account how close to retirement you are, how much anxiety you feel about your financial investments, and other considerations that could affect your risk-tolerance.
Ready to dig deeper? Let’s talk about mutual fund types.
There are many types of mutual funds. The descriptions I offer here are meant to give you a general sense of what you can choose from, but you will want to talk to your financial advisor to determine which one is right for you.
Stock funds include small-cap, mid-cap, and large-cap funds. “Cap” stands for capitalization and small, mid, and large indicate the level of market capitalization the fund has reached. (Market capitalization is determined by multiplying the stock price per share by the shares held by the shareholders.) Companies usually start off as small-cap and slowly rise to mid-cap. Most never become large-cap. As you might suspect, small-cap mutual funds are composed of shares from small-cap companies and so on.
The above described funds are further broken down into growth, value, and growth and income funds.
- A growth fund is composed of companies that are actively growing. Companies like Amazon, Facebook, Netflix are examples of stocks you might find in a growth fund.
- A value fund is one composed of stocks whose shares have lost value for some reason despite the fact that the company is valuable. The idea behind these funds is that the stocks will rise again in the future to reflect the company’s value.
- A growth and income fund includes holding of larger companies that grow and also pay a dividend. Kraft Heinz is an example of a growth and income holding.
Funds can also be broken down into
- international funds, which can include holdings from companies in countries outside of the US;
- global funds which includes companies in all countries, including the US;
- or emerging market funds, composed of small companies in emerging countries like Southeast Asia, Africa, etc.
Bond funds include short-term, intermediate-term, or long-term funds. The term indicates how long it takes the bond to mature. A short-term fund comprises bonds that take ten years or fewer, an intermediate-term fund’s bonds take ten to twenty years, and a long-term fund’s bonds takes more than twenty years to mature.
Bond funds can be further broken down into corporate bond, municipal bond, U.S. Treasury, and foreign bond funds.
Other types of funds
Balanced funds, another mutual fund designation, are funds that are balanced between stocks and bonds. They often contain 60% in large-cap stocks and 40% in treasury bonds. These mutual funds are often used for retirement. The stock holdings they contain are generally brand names that will perform steadily over time and the bonds are used to provide stability in case the market falls. They are considered a moderate risk investment.
Index funds are passively managed mutual funds. In other words, they are not managed by a person. Instead, they are tied to an index, so when the index goes up overall, the fund makes money. When the index goes down, the fund loses money. (An index is a portion of the stock market. For instance, an index could be automotive and therefore track automotive stocks only.)
Target date funds are another type of mutual fund. This type is most often used for retirement planning and is constructed toward a specific future date when the investor plans to retire. The risk factor for these funds is based on the fund-owner’s proximity to retirement. You can buy this type of mutual fund inside or outside of a retirement account like an IRA or 401k. When you buy them outside of a retirement account, you can make unlimited contributions, though they are not tax-deferred as they would be inside a retirement account.
Getting started with mutual funds is easy and you can start small, with one mutual fund and build until you have a portfolio of funds. Unless you are a seasoned investor, it is best to reach out to work with a financial advisor, who can help you determine your risk level and help you choose funds that match your time horizon and risk profile.
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